When Finance Informs the Factory

When Finance Informs the Factory

Toward a deeper understanding of finance's role in informing, advising and running a manufacturing business, along with a comprehensive assessment of globalization’s root causes and effects.

An earlier IndustryWeek article, “When Finance Runs the Factory,” ties together financial metrics, inventory policy and offshoring as its primary arguments in support of a conclusion that the office of finance is having a serious negative impact on the U.S. manufacturing industry. These supporting arguments, covering inventory, cycle time, marginal cost and globalization misunderstand the role of finance in informing, advising and running a manufacturing business. I’d like to briefly address each of the first three topics before concluding with a more comprehensive assessment of globalization’s root causes and effects.

Inventory

There would be no argument from finance that inventory be held to the lowest reasonable levels that still permit the enterprise to operate at peak efficiency, the operable word being “reasonable.” In fact, a better term would be optimal -- not too much, not too little. No manufacturing executive wants unnecessary capital being unproductively tied up in excess inventory, along with the concomitant additional carrying costs, but neither do they want to jeopardize operations by being an inventory miser.

Cash is king. In the 25 years I spent in manufacturing finance, my driving concern was the cash-to-cash cycle. I may have saved a little on up-front cash with a stringent inventory policy, but I also understood that a too restrictive inventory policy could cost me dearly in production interruptions and lost revenue, lengthening and negatively affecting the resulting cash-to-cash cycle. 

Inventory is a risk management tool. Inventory is essentially an insurance policy against the variability of the supply chain, production processes and the market, with inventory optimization as the appropriate analytical approach to balancing risk with return. Inventory optimization operates with two inputs -- a forecast plus constraints. It is the constraints, such as forecast and lead-time variability, customer-service levels, costs and capacity that incorporate the risk-management aspect. If the economic order quantity (EOQ) algorithm from such an approach recommends acting on a discount for a bulk purchase, I am inclined to trust the analytics.

Demand Driven InventoryOne cautionary note regarding inventory management comes from my colleague, Bob Davis, and his recent book, Demand-Driven Inventory Optimization, where he makes this rather counterintuitive observation: “A lot of the supply-chain productivity initiatives over the past couple of decades, such as ‘just-in-time (JIT)’ or ‘Kanban,’ have actually accomplished not much more than to simply push the inventory problem either upstream or downstream, like squeezing on a balloon, and in the process making the cost problem, on whole, worse than before ... it does not reduce costs so much as push the costs around. The result was a 5% to 10% increase in the cost of doing business with a production JIT/Kanban system.” There is no free inventory lunch--if you want to push your inventory problem to your suppliers, you will have to pay for the privilege.

Cycle Time

I was unfamiliar with Little’s Law as referenced in the article and had to it look up. Named for John Little, an MIT professor, the law bearing his name comes from probability and queuing theory, expressed algebraically as L = λW, where L is the long-term average number of customers in a stable system, λ represents the long-term average effective arrival rate, and W is the average time spent in the system. For example: Customers arrive at the rate of 10 per hour and stay an average of 0.5 hour. This means we should find the average number of customers in the store at any time to be 5.

Little’s Law has been adapted to apply to the performance of production systems, defining a relationship between Work-In-Process inventory, throughput and flow time of a production system in a steady state, taking the form: Inventory (I) = Throughput (T) x Cycle Time (C).

Since rearrangement of the terms implies that Cycle Time = WIP / Throughput, it would seem that reducing WIP while holding throughput constant will reduce cycle time. When I = C x T is reformulated as C = I / T it makes it appear as if C is the dependent variable, when in practice the cycle or flow time of a machine or production process is a relatively fixed independent variable in the short term that informs and drives inventory requirements. 

Taken out of its retail context, [Little's Law] simply is not applicable to the context of a production line."

Taken out of its retail context, where a long cycle time is meaningful in that it implies longer queues which might discourage new customers from entering the store, it simply is not applicable to the context of a production line. When retail queues get too long, store management opens more registers (i.e. increase throughput), it doesn’t close the doors. But unless there’s so much inventory it blocks the aisles and fire exits, the analogy doesn’t hold in a production environment.

I’m not saying you can’t have too much inventory (I made the case for optimization above), I merely contend that retail queues and factory machine queues are not analogous.

Simply putting a label on a ratio doesn’t make it a meaningful metric, no matter how impressive the objective of reducing cycle time might sound.

However, I do endorse inventory turns as a metric directly related to the cash-to-cash cycle. Similarly, increasing throughput is valuable in its own right as a stand-alone metric; finance says, “Go for it!”  However, if I work to increase T, by necessity the math says I will have to increase inventory to support the improved productivity. And I’ll take that to the bank as a positive outcome any day of the week.

Marginal Costs

I concede that idle fixed capacity plus idle fixed labor means my marginal cost is equal to my marginal direct material cost. This, however, is nothing but an exception-based sideshow to the main event: “What were the causes behind this unsustainable situation?”

Since marginal cost is a period-driven calculation, we can ignore hourly and weekly production fluctuations. No one is going to argue that the specific units manufactured between 2 p.m. and 4:30 p.m. last Thursday should be sold at a 75% discount because there wasn’t any scheduled demand for them at the time, and the machines would have otherwise stood idle. 

The main event would be the longer-term monthly, quarterly or full-year prospect of idle fixed resources. If the best I can do to maximize my cash-to-cash cycle investment in fixed PPE and labor is to produce and sell at a price just above variable material cost, then so be it. But that does not constitute a satisfactory, sustainable business plan.

there is more to price than just cost."

I would, however, also remind the business team there is more to price than just cost. Price should be a reflection of perceived value, moderated by competition. If the perceived value of my product has dropped to the level of the direct material cost, we have bigger problems.

Speaking of bigger problems, after leaving the short-term marginal production decisions to the experts in operations and marketing, the focus should shift to tackling the root causes for idle resources and making tough long-term decisions:

  • Do we need an improved demand forecasting capability?
  • How quickly can we repurpose the idle capacity and at what cost?
  • Is this because we are losing market share, and how should we address that?  
  • Do we have a customer satisfaction or retention problem related to quality or service?
  • Does the frequent long-term presence of idle resources indicate that we should move some production to more flexible contract manufacturing partners?
  • Is the market itself changing such that we need to permanently divest ourselves of this excess capacity ASAP?

I would want to base these decisions on the best, most accurate data and analysis available. When it comes to product cost, I’ll choose activity-based costing. Traditional, full-absorption accounting satisfies no one except for tax and regulatory authorities, providing a less-than-optimal basis for business decision making.

Activity-based costing, on the other hand, lets manufacturers make crucial pricing, production and investment decisions without arbitrarily allocating overhead and recognizing and isolating the impact of idle resources.

One of the more confusing aspects of the article is that it seems to conflate different definitions and applications of the word finance, such as investment banking, financial reporting and cost accounting, into the single word, “finance.” 

It is not, as the article states, the “job of cost accounting to provide income statements, balance sheets and other reports that are required by the SEC and IRS.” That would be the job of the financial accounting and reporting function, a role distinct from that of managerial and cost accounting. To emphasize the point, there are even separate certifications between the two domains, the CPA and the CMA. Any FP&A function worth its salt understands the importance of opportunity cost, recognizes the differences among various cost accounting methodologies, and applies this knowledge in their role as financial business advisor.

Globalization & the Church of Finance

Labor arbitrage (i.e. offshore labor) is only one of several components to the globalization that has negatively affected U.S. manufacturing. It’s a complex issue with many causes, most having their roots in factors that emerged decades ago. 

For example, consider the impact of the most important recent innovation in infrastructure: containerized shipping and all it entails, from the ships themselves to the marine terminal cranes to the railcars, the trucks and the warehouse logistics. The cost of shipping a 40-foot container from Hong Kong to Los Angeles is now in the $3,000 range -- less than a dollar per pound. There is no way retail behemoth Walmart could keep its prices reasonable on all that imported merchandise without the improvements and cost savings provided by containerized shipping.

Or consider the global political and economic stability that followed from perestroika, the fall of the Berlin Wall, and the collapse of the Soviet Union. This, combined with the growing middle class in emerging markets across the globe, made direct foreign investment both relatively safe and lucrative for the first time. Coupled with containerized shipping, the global economy would never be the same again.

But when it comes to the plight of heavy industrial and automotive manufacturing in the U.S., nothing illustrates the complex, deep history of the root causes like these three words: basic oxygen furnace.

The basic oxygen furnace, a post-war technology with 10 to 15 times the steel-making productivity as the older, open hearth process, was quickly adopted by Japan as it rebuilt its economy after the war. The U.S., emerging from the war now with considerable excess steel capacity, was understandably reluctant to upgrade to the new technology.

The result was exactly as the article describes -- the reluctance to ignore the sunk costs and make the required investment in new technology put the American steel and automobile industries at a significant disadvantage for several decades.

The Church of Finance

The Innovator's DilemmaClayton Christensen, professor at the Harvard Business School and author of The Innovator’s Dilemma, places the blame for the situation highlighted by the article on what Christensen calls the “Church of Finance.” In this instance, finance refers to investment banking, not managerial accounting.

With the Church of Finance and their capital efficiency metrics and ratios, it is no longer sufficient to make a ton of cash and call it a day. Our financial market-driven economy is obsessed with efficiency ratios -- return on assets, return on capital employed, and return on equity.

Our desire to satisfy Wall Street has resulted in a lopsided, out-of-balance approach to investments in innovation."

Unlike a scalar metric such as cash, ratios can be affected by changes in either their numerator or their denominator. And, as most experienced business and finance people know, it’s a lot easier to shrink the asset-based denominator (which would include inventory) than to increase the revenue-dependent numerator.

Our desire to satisfy Wall Street has resulted in a lopsided, out-of-balance approach to investments in innovation. Over the past several decades, the emphasis has been on reducing that denominator, decreasing the use of cash, capital, assets and equity, to the detriment of investment in disruptive innovation that could affect the numerator.

Christensen calls this the “Capitalist’s Dilemma,” and cites today’s Japan as exhibit A. This unhealthy focus on the ratios, and especially on the denominator, on capital efficiency, has led to consequences entirely predictable from the model: fewer jobs, excess capital and uninvested cash.

When the Church of Finance runs the economy, the result is the jobless recovery the U.S. is currently experiencing."

The way out of the Capitalist’s Dilemma is not entirely clear. Growing that numerator is hard work. New sales, revenue growth, new markets, new products, killer apps and killer brands. Those gifted and successful at growing the numerator become legends, precisely because it’s such a rare skill. Whereas, similar to the saying that you can’t cost-cut your way to prosperity, experts at reducing the denominator tend to remain in obscurity.

When the Church of Finance runs the economy, the result is the jobless recovery the U.S. is currently experiencing. But the Church of Finance does not directly run the factory. Corporate finance professionals are encouraged to take stock of the manufacturing environment they support. Finance has been working hard on making the transition from transaction processing to trusted business partner for a couple of decades. But if the attitude presented in “When Finance Runs the Factory” is prevalent in your organization, you have some serious trusted business partner challenges to address in your near future.


Leo Sadovy, currently responsible for manufacturing industry marketing at SAS, is a former Vice President of Finance with more than 25 years of management experience at several Fortune 50 manufacturing companies.

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